Lower of Cost or Market Method

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Lower of Cost or Market (LCM) Method

Definition

The lower of cost or market (LCM) method is an inventory valuation approach that reports inventory at the lesser of its historical cost or its current market value. Its purpose is to avoid overstating assets and income when inventory values decline or items become obsolete.

Key points

  • Ensures conservative, transparent inventory valuation.
  • Prevents overstating assets and profits by recognizing write-downs when market values fall below cost.
  • Under GAAP, inventory must be reported using the lower of cost or an appropriate measure of market value (with recent guidance emphasizing net realizable value for some methods).
  • Write-downs are recorded as an expense (often reflected in cost of goods sold or as a separate loss) on the income statement.

How LCM works

  1. Determine the historical cost of the inventory item.
  2. Determine the “market” value. Under traditional LCM, “market” is generally replacement cost bounded by:
  3. Ceiling = Net realizable value (NRV) — estimated selling price less costs to complete and sell.
  4. Floor = NRV less a normal profit margin.
  5. Compare cost and market (or NRV where required) and report the lower amount as inventory value.
  6. If market (or NRV) is lower than cost, recognize a write-down for the difference.

Example: Inventory cost = $100; market/NRV = $80 → report inventory at $80 and record a $20 write-down expense.

When and why businesses apply LCM

LCM is most relevant when inventory:
* Faces declining market prices
* Risks obsolescence
* Will likely sell for less than its purchase cost

Applying LCM helps present a more accurate financial position and matches expected recoverable amounts with reported assets.

Considerations and exceptions

  • Scope: LCM can be applied to individual items, categories, or groups of related products depending on company policy and materiality.
  • Hedges: If inventory is subject to a fair value hedge, hedge effects may be incorporated into inventory cost, potentially avoiding an LCM write-down.
  • LIFO layer recovery: Companies using LIFO may avoid interim write-downs if there is convincing evidence that prices will recover by year-end.
  • Raw materials: A write-down of raw materials may not be required if finished goods are expected to sell at or above cost.
  • Sales incentives and timing: Existing incentives or imminent price recoveries can affect whether a write-down is appropriate.

GAAP and recent guidance

LCM is a conservative, GAAP-consistent approach. Recent updates require companies using average cost or LIFO methods to measure inventory at the lower of cost or net realizable value (NRV), aligning U.S. practice more closely with IFRS and simplifying measurement for those methods.

Other inventory costing methods under GAAP

Accepted inventory costing methods include:
* First-in, first-out (FIFO)
* Last-in, first-out (LIFO)
* Weighted average cost

LCM is an additional valuation rule applied to ensure inventory is not carried above amounts expected to be realized.

Bottom line

The lower of cost or market method protects financial statement users from overstated inventory values and income by forcing recognition of losses when market values fall below cost. Recent accounting guidance has refined how market is measured for some costing methods (favoring NRV), but the underlying goal remains: present inventory at an amount that reflects its recoverable value.